Chapter 28: Problem 5

What would be the effect of increasing the banks' reserve requirements on the money supply?

Short Answer

Expert verified

In conclusion, increasing the banks' reserve requirements leads to a decrease in the money supply, as it forces banks to hold a larger proportion of their deposits as cash reserves, leaving less money available for loans. This results in a reduction in credit available in the economy, limiting the money creation process and potentially slowing down economic growth. Central banks use reserve requirements as a tool to regulate economic conditions and maintain financial stability.

Step by step solution

1. Definition of Reserve Requirements

Reserve requirements are regulations that dictate the minimum amount of cash reserves that banks must hold relative to their total deposits. This requirement is set by central banks to ensure that banks have enough cash on hand to cover withdrawals by their customers.

2. The Money Creation Process

When banks receive deposits, they can use part of that money to make loans. When a bank lends out money, it increases the money supply because the borrower then spends that money and it enters the economy. Therefore, the less money banks have to hold in reserve, the more money they can lend out, increasing the money supply.

3. How Reserve Requirements Affect Money Supply

If the banks' reserve requirements are increased, banks have to hold a larger proportion of their deposits as cash reserves and are left with less money available to lend out. This means that the amount of new loans they can make decreases, reducing the amount of new money in the economy.

4. Analyzing the Effect of Increasing Reserve Requirements

When reserve requirements are increased: 1. Banks must hold more cash relative to their total deposits. 2. They have less money available to make loans. 3. The number of new loans and amount of new credit in the economy decreases. 4. The money supply in the economy decreases as less money is being created and circulated.

5. Conclusion

In conclusion, increasing the banks' reserve requirements has the effect of decreasing the money supply. This can lead to a reduction in credit available to businesses and individuals, potentially slowing down economic growth. Conversely, decreasing reserve requirements can increase the money supply, stimulating economic growth. Central banks adjust reserve requirements as a monetary policy tool to manage economic conditions and maintain a stable financial system.